Raw Finance

Lately I have been hearing rumors and anecdotal evidence of an expected collapse in the value of the U.S. dollar, including some doomsday-type scenarios offered by currency traders (hat tip to Steve).  While I generally am not interested in extremist positions (they are inevitably wrong), they are sometimes good indicators that something is wrong.  It’s just that the end of civilation is usually not the result of an economic crisis, and our country endured some shockingly bad crises during its first 50 years of existence.  In this case, I suspect that the concern is how the U.S. government is going to pay for all of the packages and programs it has used and will use in the near future.

The Problem:  Rapid Expansion of U.S. Government Debt

As I noted in the last post, the total outlay of funds by the U.S. government to combat the severe recession in which we find ourselves is at $7 trillion and counting.  To pay for this, the government will issue more 10-, 20- and 30-year treasury bonds.  The more debt the government issues, the more interest it must pay for what it borrows.  The government then has to print money to pay the interest on the debt, because it will not be able to raise taxes until the economy had made a complete turnaround.  Even then, no tax increase will be large enough to repay the debt.  Another option for the government to lower its interest payments is to “monetize” the debt.  Monetizing debt generally means printing money and using those funds to buy back treasury bonds.  We don’t need to get bogged down in the minutia of how a government funds a deficit, my point is that all of these methods increase the money supply.

Expansion of Debt Negatively Affects Factors Involved in the Value of Dollar

If one could create a list of what factors go into the value of the U.S. dollar, or any currency for that matter, I do not believe the list could ever be thorough or accurate enough.  The reason why currencies are traded is because they have no fixed value.  The dollar is only worth what the market believes it is worth, and belief is more of an issue than most might imagine.  To keep our discussion focused, I am going to concentrate on what I, in my humble opinion, believe are three of the most important influences on the value of the dollar: (1) money supply; (2) federal funds rates; and (3) credit default swaps (CDS) prices.

Money Supply

Like most economic transactions, the value of the dollar really comes down to supply and demand.  One reason why the dollar has rallied over the past few months (see chart below) is that we are going through a period of disinflation as asset prices have corrected from all-time highs.  The price of a barrel of oil for example has dropped more than $100 from its peak in June.  As all asset classes have been dragged down, the resulting credit destruction has contracted the money supply.  Even though the government is literally throwing money at the problem, that money is not flowing through to the whole economy.  Also, demand for dollars has risen as foreign investors seek a safe haven from an investing environment where everything is losing value.  Increased demand and decreased supply equal a big rally in the value of the dollar.

[SOURCE: The Wall Street Journal]

However, the money supply is growing, and once bank lending normalizes, the massive amount of dollars issued by the government will cause inflation.  This eats at the value of the dollar, and will thus reduce demand for the currency.  Increased supply and decreased demand will equal a drop in the value of the dollar.

Interest Rates

The current federal funds rate is 1 percent.  This is low both in nominal and historical terms.  As the government continues to fight the recession, we may see a 0 percent federal funds rate.  Low rates discourage saving and encourage lending.  This practice is another way to increase the money supply.

Credit Default Swaps

CDSs seem to be discussed only in light of mortgage-backed securities.  However, there are healthy markets in CDSs for all kinds of debt, including U.S. Treasuries. One of the offshoots of the rising U.S. government debt may be a concern that the U.S. will have trouble paying off the debt (or as doomsdayers predict, will not be able to pay it off).  When concerns about U.S. default rise, so do prices on CDSs for treasuries.  Usually, the Fed would raise its rates to counter rising CDS rates.  However, if the economy will not allow for that, then the government will need to monetize its debt in order to avoid default, which would be catastrophic to future debt issuances.  Thus, the money supply would increase, and most likely dollar demand would drop sharply.

Prediction

I believe that over the next year or longer, the value of the dollar will steadily decrease, touching or breaking through its previous lows of last Spring for the reasons outlined above.  However, I do not foresee a monumental breakdown in demand for the dollar, if only because the rest of the world is going to be struggling right along with us, and the U.S. will most likely lead the world out of the recession.  Also, it appears that the economic team put together by President-elect Obama will closely monitor the money supply and take action as necessary to ensure that it does not spiral out of control.  Of course, governments by their nature never move fast enough, and that is why I predict that the dollar will give back its current rally.  But, at the same time, I see no reason to buy guns, ammo and canned goods and move to a cabin in the woods.

Anyone who is interested in investing either for or against the dollar may be interested in two exchange-traded funds: PowerShares U.S. Dollar Bullish and Bearish (ticker symbols UUP and UDN).  These funds use currency futures to earn a daily return that mimics the movement of the dollar index.